Index ETFs
Index ETF’s are structured to combine the assets of individual investors into a common pool. They uses indexes to invest in funds to achieve an agreed upon goal such as current income or capital appreciation. Index ETF’s are a type of passive index fund that functions in a way not unlike mutual funds in that they allow a entire securities portfolio to be traded in a single transaction.
Institutional investors create index exchange traded funds by depositing securities into a fund in exchange for creation units. A creation unit is a block of shares that can be traded and priced during the day on the stock exchange. Index ETF’s are usually traded on the American Stock Exchange (AMEX), but the New York and Chicago exchanges have begun to list them as well. A retail investor who is seeking to buy or sell shares from the fund has to buy or sell shares on the stock exchange in the same way any other listed stock would be traded. The many strategies used with other stocks can also be applied to index ETF shares.
This type of fund is an efficient way for retail and institutional investors to trade in way that allows specific index exposure on the various indexes. A certain sector or industry can be represented this way. A focus on a specific investment style can also be applied for value or growth or other aspects.
An index ETF’s price is usually similar but independent of net-asset-value of the fund. If a fund is demanded beyond its supply the market price of an index ETF can exceed its underlying net-asset-value. If supply exceeds demand, the price drops. Shares of an index ETF can be created of specified on a daily basis by specialists. Institutional investors are also able to redeem a lot of shares in-kind when the net-asset-value and the market price of the fund differ widely. This kind of arbitrage creates sufficient demand to minimize such a gap.
Index ETF’s are commonly structured in one of 3 ways. An exchange-traded open-end index mutual fund is a structure which is registered under the SEC investment Company Act of 1940. The dividends of such a fund are reinvested on the day they are received and the paid out quarterly. They can use derivatives and create income from the lending of securities. Institutional investors can buy and sell in-kind lots of up to 50,000 shares. Select Sector SPDR’s and iShares are examples of this type of structure.
The next type of structure is known as an exchange-traded unit investment trust. This type of structure is required to fully duplicate previously agreed upon benchmark indices. Diversification rules sometimes require the fund to deviate from these indices however. The 1940 Act requires that no fund may invest greater than 25% of its assets in a single issuer. The act also demands that the securities of diversified funds have an asset of at least 5% and may not compose more than 25% of the total fund. Non-diversified funds are limited to 50% of total fund assets. When an index contains company stocks that are weighted above this threshold, several funds will work in conjunction to optimize their holdings to reflect the proper weightings. In this type of structure dividends are not reinvested in funds, and they are paid out quarterly. Share lots in this type of structure may be created or redeemed in blocks of up to 50,000 shares. QQQ’s (Qubes), DIAMONDS, S&P 500 SPDR, and S&P 400 SPDR are examples of this structure type.
The third type of structure is the exchange-traded grant trust. These funds are not registered under the 40 Act, but they are the most similar to the model of owning the underlying shares of the fund outright. This kind of fund only changes in response to corporate actions, but otherwise remains static. These funds are allowed to be redeemed for underlying securities and individual investors are granted voting privileges to the securities. Investors receive dividends directly rather than through reinvestment. Shares of this type of fund can be created or sold in lots of 100 shares. HOLDR funds are an example of exchange-traded grant trusts.
Several aspects of index ETF’s make them an ideal vehicle for assisting investors in meeting their goals. These include: annual expense rations, tax efficiency, continuous pricing, cash equitization, trading fees, portfolio transitions, and completion strategies. The risks involved with index ETF’s are dangers such as the risk of market pricing, the occurrence of tracking errors, inherent market risks due to fluctuations, credit risks, and rate risks.